Sunday, July 14, 2013

Today's links

1---JPMorgan and Wells Fargo Feel First Chill of Rising Interest Rates, NYT
(Early warning for housing)

Even as two of the nation’s largest banks reported record profits on Friday, beneath the rosy earnings were signs that a sharp uptick in interest rates could spell trouble ahead for Wall Street and the broader housing market.

Kicking off bank earnings season, JPMorgan Chase and Wells Fargo handily beat analysts’ expectations. Profit at JPMorgan surged 31 percent, bolstered by gains in the bank’s trading and investment banking business. Wells Fargo, the biggest home lender in the country, posted a 19 percent increase in its second-quarter profit.

The gains were spread across the banks except for one important source: mortgage banking. The results showed that refinancing activity slowed, as did demand for mortgage loans.

The results could worsen. If rates continue to rise, fewer borrowers are likely to refinance or buy a house. And if the mortgage bond market weakens, banks will take a smaller gain when selling the mortgages.

While these concerns have loomed for months, the earnings on Friday offered the clearest picture yet of how the interest rate turmoil could affect the banks, whose fortunes hinge in part on their lending businesses.....

But important drivers of the returns at Wells Fargo and JPMorgan did not stem from substantial growth in the underlying businesses. Instead, they came from reduced expenses.
Wells Fargo, for example, reduced a crucial expense — building a reserve for bad loans. This move reflected improvements in the quality of loans.

In the second quarter, JPMorgan also lifted its profits by reducing loan-loss reserves by $1.5 billion. The bank defended the practice, saying it pointed to the improving condition of its loans.

2---Rising mortgage rates hit home affordability, USA Today

The much talked-about recovery of the housing market, which has buoyed home sales up from recession lows, has come about through intervention from the Federal Reserve, record low interest rates, and higher home prices that have helped borrowers across the nation improve their financial standing.
Both low interest rates and higher home prices have played a role in the housing recovery changes, but as mortgage rates begin to tick upward, housing affordability will decrease, which in turn could cause a pause in the recovery's progression.

3---The Fed's latest dilemma, sober look

...now the Fed has a new problem. The central bank's securities purchases are financed with bank reserves, which have been rising steadily in 2013 (chart below).

Source: FRB

And to many on the Fed that was justifiable as long as US commercial banks continued to expand their balance sheets. But recently that expansion has stalled.
 
To some this calls into question the effectiveness of the whole program, since the transmission from reserves into credit is so weak. The Fed is now facing the following choices:
1. slow the purchases and run the risk of shrinking credit and rising interest rates or
2. continue with the program and risk QE "side effects" without the needed credit expansion (which has stalled).
 
4----GOP edges closer to cutting food stamps, NYT
 
The Center on Budget and Policy Priorities has repeatedly showed, the food stamp program (now known as the Supplemental Nutrition Assistance Program, or SNAP) has long been one of the most effective and efficient anti-poverty programs ever devised. When counted as income, SNAP benefits cut extreme poverty nearly in half, a new study shows. Most families who get the aid have an adult who is working.
      
Now that coalition has been sundered, and the future of food stamps is threatened. If the program is not returned to the five-year farm bill, it will have to be financed through annual appropriations, which puts it at the mercy of the Republicans’ usual debt-ceiling stunts and government shutdown threats.
 
5--Q2 Tracking 1% GDP, calculated Risk
 
From Merrill Lynch:
Our tracking model now pegs 2Q GDP growth at just 1%, and we only get that high with some fairly generous bounce back assumed for some of the missing data. We don’t see anything fluky about this number: it is the third weak quarter in a row.
From MarketWatch:
Barclays ... cut its second-quarter GDP trading estimate to 1.0% from 1.6% after the trade deficit widened in May. In a note to clients, Barclays blamed the larger-than-expected increase in imports in the month for the downward revision.
J.P.Morgan also cut their Q2 forecast to 1.0% (from 2.0%).

This mid-year slowdown has been expected due to the significant drag from fiscal policy. Here is what I wrote in January: The Future's so Bright ...
The key short term risk is too much additional deficit reduction too quickly. There is a strong argument that the "fiscal agreement" might be a little too much with the current unemployment rate - my initial estimate was that Federal government austerity would subtract about 1.5 percentage points from growth in 2013 (Merrill Lynch estimate up to 2.0 percentage points including an estimate for the coming sequester agreement). This means another year of sluggish growth, even with an improved private sector (retail will be impacted by the payroll tax increase). But ex-austerity, we'd probably be looking at a decent year.

6----Coming soon: normalisation of Treasury rates, IFR

US interest rates are now pricing in a normalisation of US central bank policy in as little as three years’ time, following a dramatic readjustment of the swaps curve over the past six weeks that caught many investors completely off-guard.

The prospect of the US Federal Reserve scaling back bond purchases has caused a dramatic re-pricing of risk across markets, sending investors scrambling to recalibrate their asset allocation after the most volatile trading month this year.

The forward curve for the US 10-year swap shows just how far the “liquidity horizon” – the point when investors reckon central bank liquidity will return to normal levels – has shifted, said Gerry Fowler, head of equity and derivative strategy at BNP Paribas. “Normal” yields of 4% for the 10-year swap (that is, 2% inflation plus 2% trend real growth) are now priced in for 2015. Until recently, a return to normalised levels had not been priced in for at least another 10 years...

Despite the considerable damage inflicted upon investors’ portfolios, some see the change in central bank policy as a sensible, not to mention inevitable, outcome given improving growth prospects in the US.

“It had been the most hated rally among investors, and it felt unsustainable. Yields needed to move higher and air needed to be let out of the tyres. It’s a good thing for the market to periodically remind itself it has risk,” said Niall Cameron, head of credit trading at HSBC.

The market has since stabilised to some extent. Credit indices, which hit year wides in late June, have ground back in to levels seen at the beginning of that month. Still, many investors continue to waver over where to park their cash following the Fed’s shot across the bows.

“The key thing over the next six weeks is the sea change in central bank policy as the Fed looks to taper earlier than expected, and people start to figure out what that means for global liquidity and tighter financial conditions. It’s a very uncertain world and entry points have become less compelling as compared with late last year,” said Chris Yoshida, head of European rates sales at Morgan Stanley.

Liquidity peaking

It looks likely to herald the end, albeit gradual, of an unprecedented global liquidity regime, which was largely responsible for fuelling a rally in the first five months of the year that engulfed everything in its path.
BNP Paribas calculates that the combination of central banks hoovering up bonds through their QE programmes, the ECB’s long-term refinancing operations as well as widespread government austerity has reduced the supply of high-quality assets by over US$2trn per year. At the same time, central clearing of derivatives as well as regulations forcing banks to maintain large liquidity buffers has increased demand for high-quality assets by a further US$2trn.

“We have reached a period of peak liquidity and a point of maximum manipulation of the supply and demand curves for high quality financial assets. As a side effect, excess liquidity led people to underestimate the liquidity risk in emerging markets and high-yield bonds in particular,” said Fowler.
“Now, investors are looking to sell these types of assets on rallies rather than buy on dips, even though excess liquidity in high-quality assets is likely to persist for a while yet.”

7---Ben Bernanke is worried, Maxey argues, by previous instances when policy was tightened; 1937, 1994 and 2004. But he is also worried that easy policy will create asset bubbles., The Economist

The next link in the chain is the Fed. Ben Bernanke is worried, Maxey argues, by previous instances when policy was tightened; 1937, 1994 and 2004. But he is also worried that easy policy will create asset bubbles.
By introducing the concept of tapering to the market, Bernanke hoped to introduce volatility to interest rate markets but without significant impact on the level of interest rates themselves. Like the dodgy rock band which doesn't understand the sensitivity and feedback loops of its sound system, Bernanke tapped the microphone and the amplifiers blew up. Long term real rates rose by 1%.
The markets reacted so badly, Maxey thinks, because they didn't expect tapering to start so early. Also, the markets are less able to absorb changes of investor views.
Because of balance sheet concerns and regulatory pressure, banks are less able to take on big inventory positions to buffer flows even when prices look attractive. At the same time, the size of global fixed income markets has grown from circa $40 trillion to $100 trillion over the last ten years. This means that fixed income flows and pricing increasingly resemble a boat with water in the hull, a slight tilt and this is very little to stop the vessel lurching from one side to the other.
Add to this, China's decision to restrain credit growth in its financial sector.
It is a domestically focused decision by a new Chinese regime which is looking to bring power from the provinces back to Beijing as part of a ten year plan. At best, this is a disinflationary force because it will slow Chinese economic growth; at worst it could precipitate China's long-feared financial crisis.
All this adds up to
a three-way disinflationary impulse in an otherwise powerfully reflationary world.
No wonder the markets have been heading in contradictory directions. As Maxey says, it's the kind of event that can cause a crisis either in an individual market or at a financial institution that has not anticipated the sudden volatility.
 
 

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